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Mastering Credit Risk Management Frameworks

Ann Marie Smith

5/1/2024

A good credit risk management strategy is essential to maintain a healthy cash flow and grow a profitable business. Regardless of the size of your business, a formal credit risk management framework can provide the guidance and governance you need to make smarter decisions about extending credit to your customers.

Credit risk management is especially important for small and medium-sized businesses, which often operate on tight margins. With inflation and operating costs continuing to increase, there is growing concern. As measured by the National Federation of Independent Business (NIFB), optimism among business owners is at its lowest level since 2012.

When you consider that business bankruptcies rose more than 40% in 2023, companies need a firm hand guiding their credit policies to mitigate risk.

What Is a Credit Risk Management Framework?

A credit risk management framework is a set of guidelines used to make better decisions about credit and lower your exposure.

Things have changed quite a bit over the years. Lenders today go beyond looking at an overall credit score or making a subjective assessment. Business credit reports are significantly more detailed and give you multiple ways to identify and assess risk.

For example, a business credit report can include information such as:

  • Financial stability risk scores
  • Repayment risk
  • Credit limit recommendations
  • Days beyond payment terms
  • Creditor balances
  • Fraud alerts
  • Tradeline details
  • Family tree

This gives you more—and better—data to align your credit with your preferred risk profile.

Components of a Credit Risk Management Framework

Traditionally, five components make up a credit risk management framework. They are:

  1. Risk identification
  2. Risk measurement and analysis
  3. Risk mitigation
  4. Risk reporting
  5. Risk governance

Let’s break down each of these components.

Risk Identification

Nearly 40% of small businesses have more than $100,000 in outstanding debt. That’s money owed that may be at risk.

Risk identification examines the financial health of customers to evaluate their creditworthiness. This typically involves pulling a business credit report and looking at a customer’s credit and payment history to look for potential warning signs that might indicate a potential default.

Risk Measurement and Analysis

Once you have identified a risk, you need to assess its likelihood and impact on your business. An overall credit score on the business credit report will give you a quick assessment, but you may also want to look further to see if a company pays its bills on time, how much debt they have outstanding, and whether they have had any liens, judgments, or bankruptcies.

Risk Mitigation

With risk mitigation, you take what you’ve learned and put strategies in place to reduce your exposure. For example, depending on what you see, you may want to set limits on the amount of credit you extend, ask for a deposit upfront, or get a personal guarantee in case a business cannot pay what it owes you.

Lending is all about risk and reward. You may want to reward customers with strong credit with better terms while putting tighter control—or higher rates—on customers that are greater risks.

Risk Reporting

Risk mitigation should also apply across your portfolio. You want to understand the impact of several businesses failing to pay. By regularly tracking your overall credit risk exposure, you can catch signs of distress earlier and be better prepared. Monitoring customer accounts can uncover trouble before it hits your bottom line.

Risk Governance

Risk governance is all about the policies and procedures you put in place for credit approval and credit risk management. Everyone in your company should understand your policies and procedures, including the approval process.

You should also review your documents regularly and update your credit risk management framework to adapt to changing market and economic conditions. Each business owner will have their own comfort level when it comes to risk. Your policies need to align with your threshold. As your overall risk increases, you may need to adjust your policies to keep your debt in line with your comfort level.

Ways you can adjust your credit risk management strategies include:

  • Adjusting your criteria for extending new credit
  • Reducing your credit limits to decrease exposure
  • Tightening payment terms for customers at higher risk
  • Offering a discount for early payment
  • Requiring upfront deposits or down payments
  • Asking for letters of credit from a financial institution
  • Managing collection policies to avoid past dues

Get Business Credit Reports

Command Credit provides on-demand business credit reports from Experian, Equifax, and Dun & Bradstreet to help you make credit decisions and monitor your customers’ financial health.

Get business credit reports from Command Credit as part of your credit risk management framework.